We believe the economy is headed for a soft landing. Inflation has steadily declined from its peak in 2022 with the Federal Reserve’s preferred measure of inflation, the seasonally adjusted PCE (Personal Consumption Expenditure), last registering 2.6% (exhibit 1). While still 60 basis points above their 2% target, Fed Chairman Jerome Powell stated in his August 23rd address at Jackson Hole that “inflation is on what increasingly appears to be a sustainable path to our 2% objective” and “the upside risks to inflation have diminished”. Striking a dovish tone, the Fed believes that a resurgence in inflation is unlikely, and they can now focus on the other half of their dual mandate, supporting the labor market and maximum employment. Indeed, Powell said, “we do not seek or welcome further cooling in labor-market conditions” and pledged the Fed would do everything it can to maintain a strong labor market. An interest rate cut at the next open market committee meeting in September therefore appears all but certain.
Exhibit 1
Source: Bloomberg
The Fed’s willingness to move to expansionary policy will ultimately support higher economic activity, but while we await the lagged effects of forthcoming rate cuts there are some investors who are concerned about the outlook for the economy in the short run. Our base case for the US economy is a soft landing, and although there has been some weakness in the labor market in recent months, we don’t see enough evidence to signal an imminent recession. The Bureau of Labor Statistics (BLS) reported that the U.S. economy added 114,000 jobs in July 2024, a sharp slowdown from June, suggesting that the labor market has begun to cool. The unemployment rate also ticked up to 4.3% in July from 4.1% in June, however, this uptick was not driven by firings and layoffs, more than a third of the month over-month change was actually driven by “good” developments - essentially a larger labor force (net growth) and greater labor force participation. On a net basis, this translates to an economy maintaining its total employed workforce relative to its population.
Therefore, with job growth still positive, real wages increasing, and the market now pricing in a 100% probability of a 25 basis point Fed Funds rate cut in September, we believe the economy has successfully navigated the Fed’s interest rate hiking cycle without falling into recession – indicating the resilience of US household consumption.
Following the momentum
With the Fed now willing and able to support the economy, we are moving to a modest tactical overweight to equities in our CST multi-asset class portfolios. This equity overweight comes at the expense of fixed income. While we retain a positive outlook on fixed income, given how far and how fast yields have fallen in recent weeks (the 10 year yield stood at 4.3% on July 24, but by August 2nd it had fallen to 3.8%) we think the combination of a supportive Fed (lower interest rates) and strong equity market momentum makes equities a more compelling asset class than fixed income over a tactical time horizon.
Within equities, we are expressing our tactical overweight via QJUN, a First Trust 10% buffer ETF that tracks the Nasdaq 100 index. We prefer the mega cap growth names in the Nasdaq 100 over other parts of the market such as small caps, value, or international stocks because they continue to demonstrate strong momentum. Also, considering our outlook for an extension of the economic cycle with low but positive economic growth, we believe the companies that will perform best in the near term are those with idiosyncratic growth potential, high profitability, and strong balance sheets – namely the mega cap companies in the US that have invested heavily in scale, product innovation, and share buy-backs. In contrast, there are pockets of weakness in the economy that we believe will delay a broadening-out of economic activity in the short term, and therefore act as headwinds to the smaller, more cyclically exposed companies.
A lack of new building permits for new private housing units is one such area of weakness. Housing is an integral part of the economy, with the construction of new homes having an enormous multiplier effect on economic activity. Unfortunately, building permits have fallen to a seasonally adjusted annual rate of 1,396,000 as of July 31st 2024 (exhibit 2), which is slightly below levels last seen in late 2022 when the Fed’s rate hiking cycle caused the average 30 year fixed mortgage rate to breach 7%.
Exhibit 2
Source: Bloomberg
The manufacturing sector is another area of weakness, with the Manufacturing New Orders index registering only 47.4 - well into contraction territory (exhibit 3). While the services sector of the economy continues to expand, the manufacturing sector is suffering from weak demand, which bodes ill for for cyclical sectors of the economy such as materials and industrials.
Exhibit 3
Source: Bloomberg
As the Fed begins to cut ruts, we will likely see an increase in home building as well as an improvement in manufacturing PMIs, both of which will help broaden economic activity. But this will take some time as it will take multiple quarters for Fed policy to move from restrictive to neutral, and Fed interest rate cuts have “lagged effects” on the economy (typically 6-12 months). For now, within global equities, we favor the largest US companies with strong balance sheets who can grow their earnings per share independently of the economy.
Why we remain buffered
There is an important caveat to make regarding our willingness to move overweight large cap US growth equities. We are not moving into long-only equities. In our CST Strategy, 82% of our equity exposure has downside protection via Buffer ETF’s[1]. We are willing to allocate towards market momentum and leadership, but we respect the risks present in the market cap weighted indexes, namely high company concentration and relatively expensive valuations.
Consistent outperformance from the largest companies over the past decade has led to record levels of concentration at the index level. In fact, the 10 largest names in the S&P 500 constitute 37% of the index (see exhibit 4). Compounding this concentration risk is the fact that these 10 largest companies also have significantly higher valuations than the rest of the S&P 500 (see exhibit 5).
Exhibit 4
Source: JP Morgan
Exhibit 5
Source: JP Morgan
Concentration and expensive valuations come with elevated downside risk. For instance, if any one of the “Magnificent 7” shows disappointing progress in terms of monetizing AI, and the market perceives them as unlikely to grow into their lofty valuations, any subsequent multiple contraction in the stock would be felt strongly at the index level.
It is true that better value can be found in other parts of the stock market, for example, US small caps trade at 1x sales, international stocks trade at 1.5x sales and the Russell 1000 Value trades at 1.8x, while in comparison, the S&P 100 trades at 3.7x (exhibit 6).
Exhibit 6
Source: Bloomberg
However, we have less conviction that small caps, value and international stocks can outperform in the near term. If US large cap growth companies continue to display strong relative momentum, we will maintain a bias for these companies. We continue to monitor market leadership and the US large cap growth momentum. We look forward to an equity portfolio that tilts towards value and international equities. For now, the AI revolution continues to drive investment into the “Magnificent 7” (largest 7 US stocks) companies and through buffer ETFs we can maintain exposure to the large, market-cap weighted US indexes, but with protection against first losses to the downside.
With a soft landing in sight, we believe our overweight to equities, with a tilt towards large, US growth stocks, is well positioned to capture the market's momentum and navigate current economic trends. At the same time, our use of buffer ETFs provides added downside protection, ensuring we remain invested while mitigating concentration and valuation risks.
[1] For those who are unfamiliar with these products, Buffer ETFs are innovative exchange-traded funds that track the performance of an underlying index such as the S&P 500 but provide investors with a predetermined level of downside protection (a “buffer”). Many buffer ETFs in our portfolios have 9% downside protection. This means that if, at the end of the outcome period (usually one year), the market is down 9%, the fund will be down 0% (flat). If the market is down 10%, the fund will only be down 1%. If the market is down 11%, the fund will only be down 2%. And so on. In exchange for this protection, the funds retain capital appreciation potential up to a predetermined level (the “cap”). Currently, 9% buffer ETFs are offering upside caps in the 16% to 17% range. To illustrate the concept of a “cap”, if the market is up 16% at the end of the outcome period, a fund with a 16% cap will also be up 16%. If the market is up 17%, the fund will only be up 16%. If the market is up 18%, the fund will only be up 16%. And so on.
Historically, these types of defined outcome vehicles have only been available through certain bank and insurance products, often in the form of structured notes. These legacy products are opaque, illiquid, and come with punishingly high fees. They are also subject to the underlying credit risk of the issuer. In contrast, Buffer ETFs are daily liquid, transparent, tax-efficient, cost-efficient, and are not subject to counterparty risk.
To summarize, by accepting a limit on growth potential in the form of an upside cap, these ETFs create a built-in buffer against loss over a defined outcome period, usually one year, after which the ETF resets its exposure and buffer zone.
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